WEB CHAPTER

Cross-Border Mergers,
Acquisitions, and Valuation
LEARNING OBJECTIVES
● Examine recent trends in cross-border mergers and acquisitions

● Evaluate the motivations for MNEs to pursue cross-border acquisitions

● Identify the driving forces behind the recent surge in cross-border mergers and
acquisitions

● Detail the stages in a cross-border acquisition and show how finance and
strategy are intertwined

● Examine the difficulties in actually settling a cross-border acquisition

● Show how the complexities of postacquisition management are related to the

fulfillment of value

● Identify the legal and institutional issues regarding corporate governance and
shareholder rights as they apply to cross-border acquisitions

● Explain the alternative methods for valuing a potential acquisition target

A
though there are many pieces to the puzzle of building shareholder value, ulti-
mately it comes down to growth. Chapter 16 described the process of how an
MNE will “go global” in search of new markets, resources, productive advan-
tages, and other elements of competition and profit. A more and more popular route
to this global growth and expansion is through cross-border mergers and acquisitions.

W-1
W-2 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation

The process of identifying, valuing, and acquiring a foreign firm is the subject of this
chapter.
This chapter focuses on identifying and completing a cross-border acquisition
transaction. In addition to detailing both the valuation techniques employed and the
management of the acquisition process.
Cross-border mergers, acquisitions, and strategic alliances all face similar chal-
lenges: they must value the target enterprise on the basis of its projected performance in
its market. This process of enterprise valuation combines elements of strategy, man-
agement, and finance. Strategically, the potential core competencies and competitive
advantages of the target firm attract the acquisition. An enterprise’s potential value is
a combination of the intended strategic plan and the expected operational effective-
ness to be implemented postacquisition.
The first section of this chapter will detail the arguments and identify the trends in
cross-border acquisitions. This will focus on the particularly unique factors in the cross-
border acquisition environment. Second, we review the acquisition process. The third
section explains the corporate governance and shareholder rights issues raised in cross-
border acquisitions. In the fourth section we perform a valuation using an illustrative
case, Tsingtao Brewery Company Ltd. of China. We will cover the many different val-
uation methods employed in industry—and their limitations. The mini-case at the end
of the chapter examines the acquisition of Telecom Italia, and the associated failure of
corporate governance.

Cross-Border Mergers and Acquisitions

The 1980s and 1990s were characterized by a spate of mergers and acquisitions (M&A)
with both domestic and foreign partners. Cross-border mergers have played an impor-
tant role in this activity. The 1992 completion of the European Union’s Internal Market
stimulated many of these investments, as European, Japanese, and U.S. firms jockeyed
for stronger market positions within the EU. However, the long-run U.S. growth
prospects and political safety in the United States motivated more takeovers of U.S.
firms by foreign firms, particularly from the United Kingdom and Japan, than vice
versa. This was a reversal of historical trends when U.S. firms were net buyers of for-
eign firms rather than net sellers to foreign firms.
The latter half of the 1990s and the early years of the twenty-first century saw a
number of mega-mergers between multinationals, which changed virtually the entire
competitive landscape of their respective global markets. This same period also saw the
rise of privatization of enterprise in many emerging markets, creating growth opportu-
nities for MNEs to gain access to previously closed markets of enormous potential.

The Driving Force: Shareholder Value Creation

What is the true motivation for cross-border mergers and acquisitions? The answer is
the traditional one: to build shareholder value.
Exhibit W.1 tries, in a simplistic way, to model this global expansion. Publicly
traded MNEs live and die, in the eyes of their shareholders, by their share price. If the
MNE’s share price is a combination of the earnings of the firm and the market’s opin-
ion of those earnings, the price-to-earnings multiple, then management must strive to
grow both.
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E X H I B I T W.1
Building
Shareholder Value The Goal: Increase the share price of the firm
Means Building
Earnings
Price = EPS ⫻ [ PE ]
Increasing the Management directly Management only indirectly
share price means controls through its influences the market‘s opinion
increasing the efforts the earnings per of the company‘s earnings
earnings. share of the firm. as reflected in the P/E.

So building “value“ means growing the firm to grow earnings.

The largest growth potential is global.

Management’s problem is that it does not directly influence the market’s opinion
of its earnings. Although management’s responsibility is to increase its P/E ratio, this is
a difficult, indirect, and long-term process of communication and promise fulfillment.
Over the long term, the market—analysts, investors, and institutional stakeholders—
will look to the ability of the management to deliver on the promises made in meetings,
advertisements, annual reports, and at the stockholders’ meetings. But the opinion of
markets as reflected in P/E ratios is infamously fickle. (The astronomic share prices gar-
nered by many dot.com firms in the years before the bust is the most obvious example.)
But management does directly affect earnings. Increasing the earnings per share
(EPS) is within the direct control of the firm. In many of the developed country mar-
kets today the growth potential for earnings in the traditional business lines of the firm
is limited. Competition is fierce; margins are under continual pressure. Senior manage-
ment of the firm cannot ignore these pressures. Indeed they must continually undertake
activities to promote brand, decrease inventory investments, increase customer focus
and satisfaction, streamline supply chains, and manage all the other drivers of value in
global business. Nevertheless, they must also look outward to build value.
In contrast to the fighting and scraping for market shares and profits in traditional
domestic markets, the global marketplace offers greater growth potential—greater
“bang for the buck.” As Chapter 16 described, there are a variety of paths by which the
MNE can enter foreign markets, including greenfield investment and acquisition.

Cross-Border Mergers and Acquisitions Drivers

In addition to the desire to grow, MNEs are motivated to undertake cross-border
mergers and acquisitions by a number of other factors. The United Nations Conference
on Trade and Development (UNCTAD, formerly the U.N. Centre for Transnational
Corporations) has summarized the mergers and acquisitions drivers and forces rela-
tively well in Exhibit W.2.
The drivers of M&A activity are both macro in scope—the global competitive
environment—and micro in scope—the variety of industry and firm-level forces and
actions driving individual firm value. The primary forces of change in the global
W-4 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation

E X H I B I T W. 2
Driving Forces Behind Cross-border
Cross-Border M&A M&A activity
Changes in the Global Environment
• Technology New business
• Regulatory frameworks opportunities
• Capital market changes and risks

Firms Undertake M&As to

Strategic responses by firms
to defend and enhance their
competitive positions in a
changing environment.
• Access strategic proprietary assets
• Gain market power and dominance
• Achieve synergies
• Become larger
• Diversify and spread risks
• Exploit financial opportunities

Time

Source: UNCTAD, World Development Report 2000: Cross-Border Mergers and Acquisitions
and Development, Figure V.1., p. 154.

competitive environment—technological change, regulatory change, and capital market

change—create new business opportunities for MNEs, which they pursue aggressively.
But the global competitive environment is really just the playing field, the ground
upon which the individual players compete. MNEs undertake cross-border mergers
and acquisitions for a variety of reasons. As shown in Exhibit W.2, the drivers are
strategic responses by MNEs to defend and enhance their global competitiveness by
● Gaining access to strategic proprietary assets.
● Gaining market power and dominance.
● Achieving synergies in local/global operations and across industries.
● Becoming larger, and then reaping the benefits of size in competition and negotiation.
● Diversifying and spreading their risks wider.
● Exploiting financial opportunities they may possess and others desire.
As opposed to greenfield investment, a cross-border acquisition has a number of
significant advantages. First and foremost, it is quicker. Greenfield investment fre-
quently requires extended periods of physical construction and organizational devel-
opment. By acquiring an existing firm, the MNE shortens the time required to gain a
presence and facilitate competitive entry into the market. Second, acquisition may be
a cost-effective way of gaining competitive advantages such as technology, brand
names valued in the target market, and logistical and distribution advantages, while
simultaneously eliminating a local competitor. Third, specific to cross-border acquisi-
tions, international economic, political, and foreign exchange conditions may result in
market imperfections, allowing target firms to be undervalued. Many enterprises
throughout Asia have been the target of acquisition as a result of the Asian economic
crisis’s impact on their financial health. Many enterprises were in dire need of capital
injections from so-called white knights for competitive survival.
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Cross-border acquisitions are not, however, without their pitfalls. As with all acqui-
sitions—domestic or cross-border—there are problems of paying too much or suffer-
ing excessive financing costs. Melding corporate cultures can be traumatic. Managing
the postacquisition process is frequently characterized by downsizing to gain
economies of scale and scope in overhead functions. This results in nonproductive
impacts on the firm as individuals attempt to save their own jobs. Internationally, addi-
tional difficulties arise from host governments intervening in pricing, financing,
employment guarantees, market segmentation, and general nationalism and
favoritism. In fact, the ability to successfully complete cross-border acquisitions may
itself be a test of competency of the MNE in the twenty-first century.

The Cross-Border Acquisition Process

Although the field of finance has sometimes viewed acquisition as mainly an issue of
valuation, it is a much more complex and rich process than simply determining what
price to pay. As depicted in Exhibit W.3, the process begins with the strategic drivers
discussed in the previous section.
The process of acquiring an enterprise anywhere in the world has three common
elements: 1) identification and valuation of the target, 2) completion of the ownership
change transaction—the tender, and 3) management of the postacquisition transition.

Stage 1: Identification and Valuation

Identification of potential acquisition targets requires a well-defined corporate strat-
egy and focus.

E X H I B I T W. 3
The Cross-Border
Acquisition Process Stage 1 Stage 2 Stage 3

Strategy Identification Completion of Management of

and and valuation the ownership the postacquisition
Management of the target change transition; integration
transaction of business
(the tender) and culture

Valuation Financial Rationalization of

Financial and settlement operations;
Analysis and negotiation and integration of
Strategy compensation financial goals;
achieving synergies
W-6 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation

Identification. The identification of the target market typically precedes the iden-
tification of the target firm. Entering a highly developed market offers the widest
choice of publicly traded firms with relatively well-defined markets and publicly dis-
closed financial and operational data. Emerging markets frequently require the ser-
vices of acquisition specialists who can aid in the identification of firms—generally
privately held or government-owned firms—that not only possess promising market
prospects but may be amenable to suitors. Emerging markets pose additional prob-
lems, including scant financial data, limited depth of management, government restric-
tions on foreign purchases, and the fact that few firms are publicly traded. The growth
of privatization programs in emerging markets in the latter half of the 1990s did, how-
ever, provide a number of new targets for cross-border acquisitions that would have
been unavailable in previous times.

Valuation. Once identification has been completed, the process of valuing the tar-
get begins. A variety of valuation techniques are widely used in global business today,
each with its relative merits. In addition to the fundamental methodologies of dis-
counted cash flow (DCF) and multiples (earnings and cash flows), there are also a vari-
ety of industry-specific measures that focus on the most significant elements of value
in business lines.
For example, the case of Tsingtao Brewery in China, analyzed later in this chapter,
focuses on the valuation of a brewery business. In this industry, the cost per ton of
brewing capacity of the business is an industry-specific valuation method frequently
employed. In the field of valuation, “more is better when using valuation methods.”
The completion of a variety of alternative valuations for the target firm aids not only
in gaining a more complete picture of what price must be paid to complete the trans-
action, but also in determining whether the price is attractive.

Stage 2: Settlement of the Transaction

The term settlement is actually misleading. Once an acquisition target has been identi-
fied and valued, the process of gaining approval from management and ownership of
the target, getting approvals from government regulatory bodies, and finally determin-
ing method of compensation can be time-consuming and complex.

Tender Process. Gaining the approval of the target company has itself been the sub-
ject of some of the most storied acquisitions in history. The critical distinction here is
whether the acquisition is supported or not by the target company’s management.
Although there is probably no “typical transaction,” many acquisitions flow rela-
tively smoothly through a friendly process. The acquiring firm will approach the man-
agement of the target company and attempt to convince them of the business logic of
the acquisition. (Gaining their support is sometimes difficult, but assuring target com-
pany management that it will not be replaced is often quite convincing!) If the target’s
management is supportive they may then recommend to stockholders that they accept
the offer of the acquiring company. One problem that does occasionally surface at this
stage is that influential shareholders may object to the offer, either in principle or
based on price, and therefore feel that management is not taking appropriate steps to
protect and build their shareholder value.
The process takes on a very different dynamic when the acquisition is not sup-
ported by target company management—the so-called hostile takeover. The acquiring
 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation W-7

company may choose to pursue the acquisition without the target’s support and go
directly to the target shareholders. In this case the tender offer is made publicly,
although target company management may openly recommend that its shareholders
reject the offer. If enough shareholders take the offer, the acquiring company may gain
sufficient ownership influence or control to change management. During this rather
confrontational process it is up to the board of the target company to continue to take
actions consistent with protecting the rights of shareholders. The board may need to
provide rather strong oversight of management during this process, to ensure that
management does not take actions consistent with its own perspective but not with
protecting and building shareholder value.

Regulatory Approval. The proposed acquisition of Honeywell International (a

recent merger of Honeywell US and Allied-Signal US) by General Electric (USA) in
2001 was something of a watershed event in the field of regulatory approval. General
Electric’s acquisition of Honeywell had been approved by management, ownership,
and U.S. regulatory bodies.
The final stage was the approval of European Union antitrust regulators. Jack
Welch, the charismatic chief executive officer and president of General Electric, did
not anticipate the degree of opposition that the merger would face from EU authori-
ties. After a continuing series of demands by the EU that specific businesses within the
combined companies be sold off to reduce anticompetitive effects, Welch withdrew the
request for acquisition approval, arguing that the liquidations would destroy most of
the value-enhancing benefits of the acquisition. The acquisition was canceled. This case
may have far-reaching effects on cross-border M&A for years to come, as the power of
regulatory authorities within strong economic zones like the EU to block the combi-
nation of two MNEs, in this case two U.S.-based MNEs, may foretell a change in regu-
latory strength and breadth.

Compensation Settlement. The last act within this second stage of cross-border
acquisition is the payment to shareholders of the target company. Shareholders of
the target company are typically paid either in shares of the acquiring company or in
cash. If a share exchange occurs, which exchange may be defined by some ratio of
acquiring company shares to target company shares (say, two shares of acquirer in
exchange for three shares of target), the stockholder is typically not taxed. The share-
holder’s shares of ownership have simply been replaced by other shares in a nontax-
able transaction.
If cash is paid to the target company shareholder, it is the same as if the share-
holder has sold the shares on the open market, resulting in a capital gain or loss (a gain,
it is hoped, in the case of an acquisition) with tax liabilities. Because of the tax ramifi-
cations, shareholders are typically more receptive to share exchanges so that they may
choose whether and when tax liabilities will arise.
A variety of factors go into the determination of type of settlement. The availabil-
ity of cash, the size of the acquisition, the friendliness of the takeover, and the relative
valuations of both acquiring firm and target firm affect the decision. One of the most
destructive forces that sometimes arise at this stage is regulatory delay and its impact
on the share prices of the two firms. If regulatory body approval drags out over time,
the possibility of a drop in share price increases and can change the attractiveness of
the share swap. The following Global Finance in Practice W.1 illustrates the problems
firms confronted recently in settling cross-border acquisition with shares.
W-8 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation

Global Finance in Practice W.1

Cash or Shares in Payment
One factor influencing not only the number but the
method of payment used in cross-border mergers
and acquisitions is the equity “altitudes” of many
MNEs. One of the major drivers of cross-border M&A
growth in 1999 and 2000 was the lofty levels of
equity values. Many MNEs found the higher equity
prices allowed what the financial press termed
“shopping sprees” in which the acquiring firms could
afford more M&As as a result of inflated equity
prices. This allowed them to bid higher for potential
targets and then pay with their own shares.
But 2001 was different. Falling equity prices in
most of the major equity markets of the world made
acquisitions much more costly prospects than in the
previous years. Shareholders of target firms were no
longer interested in being paid in shares, demanding
cash payments at significant premiums. (Premiums
over the latter half of the 1990s and into 2000 and
2001 averaged between 48% and 55% over existing
share values prior to the acquisition offers.)
With slower economies and lower growth
prospects, even the banking sectors were increas-
ingly critical of grandiose promises of M&A synergies
and benefits in general. As banks and other potential
cash providers looked upon potential M&A deals
with increasing scrutiny, sources of debt for cash
payments also became more scarce. The financing
for settlement made cross-border M&A activity
much tougher to complete.

Stage 3: Postacquisition Management

Although the headlines typically focus on the valuation and bidding process in an
acquisition transaction, posttransaction management is probably the most critical of
the three stages in determining an acquisition’s success or failure. An acquiring firm
can pay too little or too much, but if the posttransaction is not managed effectively, the
entire return on the investment is squandered. Postacquisition management is the
stage in which the motivations for the transaction must be realized. Those reasons, such
as more effective management, synergies arising from the new combination, or the
injection of capital at a cost and availability previously out of the reach of the acquisi-
tion target, must be effectively implemented after the transaction. The biggest prob-
lem, however, is nearly always melding corporate cultures.
As painfully depicted in the case of British Petroleum (United Kingdom) and
Amoco (United States) in the following Global Finance in Practice W.2, the clash of
corporate cultures and personalities pose both the biggest risk and the biggest poten-
tial gain from cross-border mergers and acquisitions. Although not readily measurable
like price/earnings ratios or share price premiums, in the end the value is either gained
or lost in the hearts and minds of the stakeholders.

Corporate Governance and Shareholder Rights

By takeover bid (tender offer) we mean an unsolicited offer by an unaffiliated third party
and/or his group (“Bidder”) to acquire enough voting shares of a target company
(“Target”) in another jurisdiction so that the shares acquired, plus the shares held before
the offer was made, give Bidder control in fact or in law of the Target.
—“Constraints on Cross-Border Takeovers and Mergers,” International Bar Association
for International Capital Markets Group, International Business Lawyer, 1991
 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation W-9

Global Finance in Practice W.2

Clashing Corporate Cultures at British Petroleum and Amoco
A popular joke in Amoco hallways goes: What’s the giant family of entrepreneurial small businesses.
British pronunciation of BP-Amoco? BP—the Amoco The system clashed badly with Amoco. More like a
is silent. classic pyramid, Amoco had strict reporting lines and
heavy internal bureaucracy. Managers often spent
LONDON—BP and Amoco called it a merger of
months negotiating contracts with internal busi-
equals. But over coffee and sandwiches one day in
nesses. Amoco’s executive suite on the 30th floor in
the BP cafeteria here, Amoco Corp. executives discov-
Chicago was a formal corridor of closed doors and
ered that British Petroleum PLC had other plans.
strict schedules. BP’s fourth-floor suite in London is
During a conference of 20 top executives from
an open-plan space with glass walls, where top exec-
both companies last fall, Rodney Chase, then BP’s
utives breeze in and out of each other’s offices.
deputy chief executive, unveiled the blueprint for the
Company memos began showing up with British
merged company. It would be led by BP manage-
spellings, prompting complaints in the BP Amoco
ment, run with BP’s structure and infused with BP’s
newsletter about use of the words “organisation”
do-or-die culture. Anyone who didn’t agree was wel-
and “labour.” BP jargon was lost on some Amoco
come to join the 10,000 other workers who were
executives. In meetings, BP’s managers lived on “hard
being fired.
targets” that had to be met, while Amoco talked
In Chicago during negotiations, Mr. Browne [BP’s
about “aspirations” that were only occasionally
chief executive] and Amoco Chief Executive
reached. BP raved about “peer groups,” while Amoco
Lawrence Fuller wrestled with the question of man-
talked about “strategic-planning councils.”
agement control. It was clear that BP would be the
The culture clash came to a head in the cafeteria
acquirer, since it was larger, but Mr. Fuller wondered
meeting last fall at BP headquarters. While most
whether the two companies could combine the “best
managers expected BP would dominate the merged
of both” management worlds. Mr. Browne was
company, few anticipated that its grip would be so
unequivocal. “It was not negotiable for us,” he said in
strong. During the all-day conference, Amoco man-
a recent interview. “We had developed a structure
agers argued the case for a centralized structure,
and systems that had worked for us, and we were
while their BP counterparts said it wouldn’t work.
anxious to apply it to a larger company.”
“You’re not interested at all in our ideas,” said one
Indeed, at the heart of BP is an unusual manage-
Amoco executive. Another said: “We weren’t pre-
ment structure and culture that it aims to stamp on
pared for this.” Sensing a crisis, Mr. Fuller stood up, a
other companies. The system grew from the com-
BP executive says, and gave his troops a final order:
pany’s near-fatal crisis in 1992, when then-CEO
“We’re going to use the BP systems, and that’s that.”
Robert Horton was ousted in a boardroom coup, the
company’s dividend was cut in half and a single
Abstracted from “Slash and Clash: While BP Prepares New U.S.
quarter’s loss topped $1 billion. The subsequent Acquisition, Amoco Counts Scars,” Robert Frank and Steve Liesman,
restructuring essentially turned the company into a The Wall Street Journal, 3/31/99, A1, A8.

The Tender and Shareholder Rights

One of the most controversial issues in shareholder rights is at what point in the accu-
mulation of shares the bidder is required to make all shareholders a tender offer. For
example, a bidder may slowly accumulate shares of a target company by gradually buy-
ing shares on the open market over time. Theoretically, this share accumulation could
continue until the bidder had 1) the single largest block of shares among all individual
shareholders; 2) majority control; or 3) all the shares outright. Every country possesses
W-10 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation

a different set of rules and regulations for the transfer of control of publicly traded cor-
porations. This market, the market for corporate control, has been the subject of enor-
mous debate in recent years.
The regulatory approach taken toward the market for corporate control varies
widely across countries. The elements of the regulation of cross-border takeovers typ-
ically includes the following 10 elements.
1. Creeping Tenders. Many countries prohibit creeping tenders, the secret accumula-
tion of relatively small blocks of stock, privately or in the open market, in a pre-
liminary move toward a public bid. This prohibition is intended to promote public
disclosure of bids for takeovers.
2. Mandatory Offers. Many countries require that the bidder make a full public ten-
der offer to all shareholders when a certain threshold of ownership has been
reached. This requirement is intended to extend the opportunity to all sharehold-
ers to sell their shares at a tender price to a bidder gaining control, rather than
have the bidder pay the tender price only to those shareholders it needs to garner
control.
3. Timing of Takeovers. A wide spectrum of different time frames apply to takeover
bids. This is typically the time period over which the bid must be left open for each
individual tender, withdrawal of tender, or revision of tender. The purpose of estab-
lishing a time frame is to allow bidders and targets alike to consider all potential
offers and for information regarding the tender to reach all potential shareholders.
4. Withdrawal Rights. Most countries allow any security to be withdrawn as long as
the bid is open. In some countries a competing bid automatically revokes all
acceptances as long as the bid remains open. The right of revocation is to protect
shareholders against tendering their shares early at lower prices than may be gar-
nered by waiting for a later offer by any competing bidder.
5. Market Purchases During Bid. Some countries allow the bidder to purchase
shares in the open market during the public tender with public disclosure. Many
countries, however, prohibit purchases absolutely during this period. This prohibi-
tion is to protect against any potential market manipulation by either bidder or
target during the tender period.
6. Market Sales During Bid. Some countries prohibit the sale of the target com-
pany’s shares by the bidder during the tender offer period. This rule is to protect
against any potential market manipulation by either bidder or target during the
tender period.
7. Limitation of Defenses. Some jurisdictions limit the defensive tactics a target may
take during a public tender offer. In many countries this limitation has not been
stated in law but has been refined through shareholder law suits and other court
rulings subsequent to measures taken by target company management to frustrate
bidders. It is intended to protect shareholders against management taking defen-
sive measures that are not in the best interests of shareholders.
8. Price Integration. Most countries require that the highest price paid to any share-
holder for their shares be paid to all shareholders tendering their shares during the
public tender. Some countries require that this price be also provided to those sell-
ing shares to the bidder in the prebid purchases as well. Although intended in prin-
ciple to guarantee equity in price offerings, this is a highly complex provision in
many countries that allow two-tier bids.
 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation W-11

9. Proration of Acceptances. Most countries which regulate takeovers require

proration when a bid is made for less than all the shares and more than the maxi-
mum is tendered. Some countries do not allow a bid to be made for less than all
the shares once the mandatory offer percentage has been reached.
10. Target Responses. Many countries require that the board of directors of the tar-
get company make a public statement regarding their position on a public tender
offer within a time frame following the tender. This requirement is intended to dis-
close the target’s opinions and attitudes toward the tender to the existing share-
holders. As illustrated in the following Global Finance in Practice W.3, the
complexity of issues over minority shareholder rights and the constant changes in
regulatory policy continue globally.

Illustrative Case: The Potential Acquisition

of Tsingtao Brewery Company Ltd., China
In January 2001, Anheuser Busch (AB) was considering acquiring a larger minority
interest in Tsingtao Brewery Company Ltd., China, the largest brewer in China. AB
had originally acquired a 5% equity interest (US$16.4 million) in 1993 when Tsingtao
had first been partly privatized. AB now considered Tsingtao an even more attractive
investment. The key questions to be answered were
● The valuation of Tsingtao’s share price in an illiquid Chinese equity market
● The percentage of Tsingtao’s total equity that could be purchased

Global Finance in Practice W.3

Vodafone Hostile Acquisition of Mannesmann
Once a firm has gained majority control of a target,
many countries require that the remaining minority
shareholders tender their shares. This requirement is
to prevent minority shareholders from hindering the
decision-making process of the owners, or requiring
the owners to continue to take actions or incur
expenses to serve a few remaining minority share-
holders.
One example of this abuse was the case of
Vodafone’s acquisition of Mannesmann of Germany
in 2000. By August 2001 Vodafone had gained own-
ership of 99.4% of Mannesmann’s outstanding
shares. Because minority shareholders holding a
total of 7,000 shares refused to sell, and were not
required to sell under German law even though the
majority of shareholders had decided to sell the firm,
Vodafone was required to continue to hold stock-
holder’s meetings in Germany for their benefit.
Under German corporate governance laws, because
this was a cross-border acquisition, minority share-
holders could not be forced to tender their shares. If,
however, the acquisition had been domestic, these
same minority shareholders would have been
required to sell their shares at the publicly tendered
price.
The Vodafone acquisition of Mannesmann is con-
sidered by many as a watershed event in Continental
European mergers and acquisitions history. The
acquisition marked the first large-scale cross-border
hostile takeover in recent times. After Vodafone’s
takeover, the German federal government initiated
legislation for the governance of acquisitions and a
procedure for the future “squeeze out” of minority
shareholders.
W-12 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation

● The terms of settling the transaction

● The prospects for AB to influence Tsingtao’s operations after the acquisition of a
larger equity stake
● The degree of future compatibility between the two corporate cultures
● The potential for future rationalization of operations

The Challenge and the Opportunity

Tsingtao Brewery Company Ltd. is the largest brewer in China. The first beer manu-
facturer in modern times, Tsingtao traced its roots to Tsingtao Brewery Factory estab-
lished in 1903 in Qinqdao, China by German immigrants. But much had changed in a
century of Chinese history and development. Tsingtao in January 2001 was a publicly
traded company in an increasingly open marketplace. Tsingtao operated 43 breweries,
2 malt plants, and 49 distribution companies covering 15 provinces in China. It was
considered to be the number-one branded consumer product exported from China,
selling under a variety of brews including Dragon, Phoenix, and Premium. Tsingtao
was also China’s largest single consumer product exporter, and was continuing to
expand, with exports to more than 30 countries. Tsingtao and its two largest rivals,
Beijing Yanjing and Guangzhou Zhujiang, were now in the midst of a highly competi-
tive market. There were an estimated 800 breweries in China. Consolidation of brew-
ers was the only method of survival.
The company was gaining the attention of investors inside and outside of China.
The value proposition for Tsingtao was increasingly clear: it had gained the upper hand
in its market through recent acquisitions, acquisitions which would now begin to add
earnings with rationalization and modernization through Tsingtao’s operational excel-
lence. Tsingtao seemed positioned for strong earnings growth, and was increasingly
viewed as a potential acquisition target.
By early 2001, Tsingtao was struggling with the postmerger digestion of its acqui-
sition binge, in addition to finding itself under heavy debt-service pressures from the
rising debt used to finance the acquisitions. Management concluded that the com-
pany’s debt burden—and bright prospects for future earnings and cash flows—made
raising additional equity both necessary and feasible.
● Tsingtao’s Operational Excellence. Tsingtao was known for its operational excel-
lence. It had worked constantly throughout the 1990s to increase the efficiency of
its operations, specifically in its use of net working capital. But the task was com-
pounded by the multitudes of acquisitions of small regional operators that were
small in scale and low in technology. While sales per day had more than doubled
from Rmb4.4 million (1998) to Rmb9.4 million (2000), total net working capital
had actually fallen by two thirds, from Rmb676.7 million to Rmb201.5 million. The
net working capital to sales ratio had fallen from 0.42 to only 0.06 in 2000.
● Tsingtao’s Operating Results. Tsingtao has enjoyed rapid sales growth, both from
existing business units and through acquisition. The company’s gross margin and
operating margin had remained stable over recent years. This was a significant
accomplishment given the many acquisitions made in recent years.
In general, it appeared that Tsingtao had 1) been growing rapidly; 2) maintaining
a gross profit margin which was healthy for its industry—despite taking on 34 acquisi-
tions in the past four years; 3) suffered from higher depreciation and amortization
 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation W-13

expenses related to modernization and acquisition efforts, respectively; and 4) demon-

strated a declining overall profitability as a result.

Measures of Cash Flow

Financial theory has traditionally defined value as the present value of expected future
cash flows. We then need to isolate the gross and free cash flows of Tsingtao for valua-
tion purposes, and Tsingtao’s statement of cash flows is a good place to start.
The statement of cash flows is constructed in three segments, operating activities,
investing activities, and financing activities. Tsingtao’s operating activities are illustrated
in the top portion of Exhibit W.4. They begin with earnings before tax, then reduce cash
flows by taxes paid (cash taxes), add back depreciation and amortization expenses, and
finally add changes in net working capital.
Depreciation and amortization are defined as noncash expenses. Cash expenses
(capex) are for labor or materials purchased by the firm, where cash payments must be
paid to the providers of these inputs. Depreciation is a charge for investments made in
capital equipment. Amortization is a charge for investments made in other companies
(acquisitions) over and above the value of the assets purchased. Although they are
deductible expenses for tax purposes, cash is never paid out by the firm. The deprecia-

E X H I B I T W. 4
Tsingtao Brewing Statement of Cash Flows
Company Ltd.,
Operating Cash Flow Calculation Acronym 1998 1999 2000
Measures of
Cash Flow Earnings before taxes EBT 63.2 72.9 113.3
(millons of Rmb) Less corporate income tax (21.4) (29.0) (34.0)
Add back depreciation and amortization D&A 132.1 180.4 257.6
Less additions to net working capital Chg NWC (148.3) 475.7 134.8
Operating cash flow 25.6 700.0 471.7
Cash Flows for Valuation
Calculation of NOPAT Acronym 1998 1999 2000
Earnings before interest and taxes EBIT 111.3 127.9 207.3
Less taxes (recalculated) 30% (33.4) (38.4) (62.2)
Net operating profit after taxes NOPAT 77.9 89.5 145.1

Calculation of Operating Cash Flow

Net operating profit after taxes NOPAT 77.9 89.5 145.1
Add back depreciation and amortization D&A 132.1 180.4 257.6
Operating cash flow OCF 210.0 269.9 402.7

Calculation of Free Cash Flow

Net operating profit after taxes NOPAT 77.9 89.5 145.1
Add back depreciation and amortization D&A 132.1 180.4 257.6
Less additions to net working capital Chg NWC (148.3) 475.7 134.8
Less capital expenditures Capex (286.1) (1,530.0) (1,330.0)
Free cash flow FCF (224.4) (784.4) (792.5)
W-14 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation

tion and amortization expenses must therefore be added back in for calculation of
actual cash flows.
Net working capital (NWC) is the net amount of capital that the firm invests in the
actual production and sales of its product. It is calculated as follows:

NWC = (Accounts receivable + inventories) ⫺ (accounts payable)

Intuitively, these are the line items of the company’s balance sheet that change spon-
taneously with sales. For example, for Tsingtao to make a sale it must purchase hops
and barley (accounts payable), brew its various beers (inventory), and make sales to
distributors (accounts receivable). Net working capital is typically a positive number
because receivables and inventories exceed accounts payable for most firms in most
industries (about 99% of the time).

Valuation Cash Flows. Operating cash flow as calculated and recorded on the state-
ment of cash flows is not the measure of cash flow we need for valuation purposes. The
lower half of Exhibit W.4 illustrates the calculation of net operating profit after-tax and
free cash flow for valuation purposes. Net operating profit after taxes (NOPAT)—in all
its various forms—is calculated as follows:

Net operating profit after-tax (NOPAT) = Operating profit ⫺ taxes

= EBITDA ⫺ taxes
= EBT + depreciation + amortization +
interest ⫺ taxes

For Tsingtao in 2000, net operating profit after taxes (NOPAT) was a positive
Rmb145.1 million. The three versions are shown to aid in deciphering the many abbrevi-
ations and terms so frequently confronted in earnings and valuation analyses in practice.
NOPAT is a cash flow measure of basic business profitability. What it does not con-
tain, however, are the two areas of investment made by Tsingtao as the company con-
tinued to sustain and grow the business. Sustaining a business requires investment in
NWC and capex. Any increase in NWC is a reduction of cash flow, any decrease an
increase in cash flow. Capex is any new investment to replace old equipment, to
acquire new equipment and technology, or acquire other businesses, and reduces avail-
able free cash flow. The addition of these new investment drains on cash flow to
NOPAT create the desired measure of cash flow for valuation purposes, free cash flow:

Free cash flow (FCF) = NOPAT + changes in NWC ⫺ capex

Tsingtao’s free cash flow in 2000 was a negative Rmb792.5 million. Although
Tsingtao’s operations are generating a substantial positive cash flow after taxes, and
initiatives to reduce net working capital have added significant cash flow, the firm’s
modernization and acquisition strategies have required substantial capital expendi-
tures. The net result is a negative free cash flow for the year 2000.

Tsingtao’s Discounted Cash Flow Valuation

Now that Tsingtao’s current financial results have been analyzed and decomposed, we
turn our attention to what Tsingtao’s discounted future cash flow will look like. There
are three critical components to construct a discounted cash flow valuation of
 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation W-15

E X H I B I T W. 5
Discounted Cash Flow Valuation of Tsingtao Brewing Company Ltd. (millions of Rmb)

Actual 1 2 3 4 5
Sales Forecast Assumption 2000 2001 2002 2003 2004 2005
Sales growth rate assumption 25% 20% 15% 10% 10%
Sales 3,448.3 4,310.4 5,172.5 5,948.3 6,543.1 7,197.5
Calculation of Discounted Cash Flow Value
NOPAT 4.2% 145.1 181.0 217.2 249.8 274.8 302.3
Depreciation and amortization 7.5% 257.6 276.9 297.7 320.0 344.0 369.8
Operating cash flow 402.7 458.0 514.9 569.8 618.8 672.1
Less additions to net working capital 1.0% 134.8 (43.1) (51.7) (59.5) (65.4) (72.0)
Less capital expenditures 2.5% (1,330.0) (107.8) (129.3) (148.7) (163.6) (179.9)
Free cash flow (FCF) (792.5) 307.1 333.9 361.7 389.8 420.2
Terminal value (and assumed
growth rate) 1.0% 4,715.6
Expected FCF for discounting 307.1 333.9 361.7 389.8 5,135.8
Present value factor
(and discount rate) 10.00% 0.9091 0.8264 0.7513 0.6830 0.6209
Discounted FCF 279.2 275.9 271.7 266.3 3,188.9
Cumulative discounted FCF 4,282.0
Less present value of debt capital (2,093.0)
Residual equity value 2,189.0
Shares outstanding (millions) 900.0
Equity value (Rmb/share) 2.43
Spot exchange rate (Rmb/HK$) 1.0648
Equity value (HK$/share) 2.28

Note: The discounted cash flow analysis is based primarily on sales expectations. Sales growth rate assumptions are used to generate sales expecta-
tions, which are in turn used for estimates of NOPAT (assumed as 4.2% of sales), depreciation and amortization (assumed as 7.5% of sales), additions to
net working capital (assumed 1.0% of sales), and capital expenditures (assumed 2.5% of sales). Free cash flow is discounted at the 10% weighted aver-
age cost of capital. The terminal value for this baseline analysis assumes a 1% perpetual growth rate in free cash flow.

Tsingtao: 1) expected future free cash flows; 2) terminal value; and 3) the risk-adjusted
discount rate.

Free Cash Flow Forecast. Forecasting Tsingtao’s future free cash flows requires fore-
casting NOPAT, net working capital, and capital expenditures individually.
The source of value of Tsingtao was its operating profits and the recent acquisi-
tions that were expected to grow and improve in both sales and profitability with con-
tinued technology and management injections. NOPAT was expected to grow 25% in
2001, 20% in 2002, 15% in 2003, and 10% in 2004 and 2005. The NOPAT forecast and
discounted cash flow valuation is shown in Exhibit W.5. With rapid growth forecast,
NWC was now expected to be maintained at roughly 5.8% of sales throughout the
analysis period.
W-16 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation

Most firms have relatively poor capabilities to plan for needed replacement invest-
ment or technological upgrades with innovations. Capital expenditures had been enor-
mous in 1999 and 2000 as a result of the 29 acquisitions made in those two years alone.
Although few additional acquisitions were planned by Tsingtao beginning in 2001, the
capital investment needed to modernize many of the acquired properties would
require substantial outlays for years to come. Capital expenditures were estimated to
be 2.5% of total sales through 2005.

Discount Rate. The discount rate to be used for Tsingtao’s valuation would be the
company’s weighted average cost of capital. Assuming a 34% corporate tax rate and a
pre-tax cost of debt of 8.00% per annum (the cost of Tsingtao’s most recent debt), the
after-tax cost of debt was estimated at 5.28% per annum.
The cost of equity was calculated using the capital asset pricing model. Using the
Hong Kong market as the best indicator of equity valuation, the risk-free rate is
7.000% per annum, the equity risk premium is 6.700% per annum, and the beta of
Tsingtao’s H-shares on the Hong Kong stock exchange is 0.80:

Cost of equity = k Tsingtao

e = k rf + β (k m − k rf ) = 7.000 + 0.80(13.700 − 7.000 ) = 12.36%

The final component needed for the calculation of Tsingtao’s weighted average cost
of capital is the weights of debt and equity in its target capital structure. Tsingtao’s man-
agement considered a 1/3 debt and 2/3 equity capital structure appropriate over the
long-term. Using these weights and plugging in the 12.68% cost of equity and 5.28%
cost of debt, Tsingtao’s weighted average cost of capital (WACC) was calculated as:
⎛ Equity ⎞ ⎛ Debt ⎞
WACC = ⎜ × ke⎟ + ⎜ × k d × (1 − tax )⎟ = ( 0.667 × 12.36%) + ( 0.333 × 5.28%) = 10.00%
⎝ Capital ⎠ ⎝ Capital ⎠
This WACC is used to discount the future cash flows of Tsingtao for valuation
purposes.

Terminal Value. The terminal value is critical in discounted cash flow valuation
because it must capture all free cash flow value flowing indefinitely into the future
(past the 2001–2005 period shown). Assuming a discount rate of 10.00%, a free cash
flow growth rate into the future of 1.00% per annum (conservative), the terminal value
as captured in year 5 of the analysis, using a constant dividend growth model formula-
tion, was
FCF2005 (1 + g ) 420.2(1 + 0.0100 )
Terminal value = = = Rmb4, 715.6
k wacc − g 0.1000 − .0100
This terminal value enters the discounted cash flow in 2005 in Exhibit W.5 and rep-
resents all expected free cash flows arising in all years after that.1

DCF Valuation. The present value of all future expected cash flows is the total
enterprise value. Enterprise value is the sum of the present values of both debt and
equity in the enterprise. Tsingtao’s equity value is then found by deducting the net debt

1An alternative method frequently used in valuation analysis is to assume some multiple of net operating cash flow in the final
year considered. In this case, assuming a multiple of 10, the terminal value for Tsingtao would be estimated at Rmb4,202 (10 ×
Rmb420.2). This technique is particularly applicable in leveraged buyouts (LBOs) and private equity ventures where the real value
and purpose of the initial purchase is the eventual sale of the enterprise at a future date.
 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation W-17

due creditors and any minority interests. Total equity value divided by total shares
outstanding is the fair value of equity per share. The baseline discounted cash flow
valuation of Tsingtao is Rmb2.43/share (HK$2.28).

Valuation by Multiples of Earnings and Cash Flows

The valuation of businesses of all kinds, small or large, domestic or multinational,
goods or services, has long been as much art as science. The use of multiples, in which
a ratio for the subject firm is compared to comparable ratios for competitors or recent
acquisitions, is one of these more artistic processes. Similar in logic to the ratio analy-
sis used in traditional financial analysis, it simply presents how the firm stacks up
against industry comparables. Some of the most widely used measures include the P/E
ratio (price/earnings-per-share), P/S ratio (price/sales), market-to-book (M/B) ratio,
and a variety of ratios that compare enterprise value (EV) to either earnings or cash
flows. Each of these ratios includes a market-determined value, either explicitly in the
numerator or used in calculating market capitalization. This is then combined with val-
ues taken from the firm’s own financials, either in the form of earnings, cash flow, or
market capitalization.

P/E Ratio. The P/E ratio is by far the most widely used of the valuation ratios. Simply
stated, the P/E ratio is an indication of what the market is willing to pay for a currency
unit of earnings. But more importantly, it is an indication of how secure the market’s
perception is about the future earnings of the firm. Coca-Cola has long been a prime
example of an MNE whose P/E ratio, typically ranging between 35 and 42, is an indi-
cator of how sustainable global earnings and earnings growth are in the eyes of share-
holders. Markets do not pay for past or present earnings. An investor purchasing a
share today is taking a long position on the basis of what earnings are expected to do
in the future—from that moment on.
Because Tsingtao is traded most heavily on the Hong Kong stock exchange, and
that exchange is relatively more liquid and open to global investors than the Shanghai
stock exchange, we shall focus on the P/E ratio calculations and comparisons of the
Hong Kong listing for Tsingtao. Tsingtao’s earnings per share for 2000 were Rmb61.3
million on 900 million outstanding shares (EPS of Rmb0.068 or HK$0.0640 assuming
an exchange rate of Rmb1.0648/HK$). The closing share price for 2000 in Hong Kong
was HK$2.20/share. The closing P/E ratio for Tsingtao in Hong Kong for 2000 was then
Tsingtao Current share price in HK$ HK$2.20
PE ratioHong Kong = = = 34
⎡ Earnings for 2000 in HK$ ⎤ ⎡ HK$57, 569, 497 ⎤
⎢ ⎥ ⎢ ⎥
⎢⎣ Outstanding shares ⎥⎦ ⎢⎣ 900, 000, 000 shares ⎥⎦
Tsingtao’s P/E of 34 was quite high compared to the Hong Kong stock exchange’s
H-share P/E average of 12 (a ratio of 2.83:1).
If we recall our earlier statement that markets do not pay for past or present earn-
ings, then we should also probably calculate Tsingtao’s P/E ratio not on current earn-
ings but on future earnings. This would then be compared with the Hong Kong stock
exchange’s share prices recalculated on expected earnings. Deutsche Bank Securities
estimated the 2001 forecast P/E ratio for Tsingtao as 28.8 compared to its forecast of
the Hong Kong H-share market’s average of 8.2. This is a ratio of 3.5:1, an even higher
relative measure than before. Clearly, the market believes that Tsingtao’s earnings
would be either relatively riskless into the future or that the earnings would be signif-
icantly higher in the near future.
W-18 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation

M/B Ratio. The M/B ratio provides some measure of the market’s assessment of the
employed capital per share versus what the capital cost. The book value of a firm is the
value of common stock as recorded on the firm’s balance sheet plus the retained earn-
ings (cumulative capital reinvested from earnings). If the M/B ratio exceeds 1, the
implication is that the firm’s equity is currently valued in excess of what stockholders
invested in the firm. Like the P/E ratio, the magnitude of the M/B ratio, as compared
with its major competitors, reflects the market’s perception of the quality of the firm’s
earnings, management, and general strategic opportunities.
The M/B ratio focuses on equity in both the numerator and denominator, and is a
mix of market value (numerator) and historical accounting value (denominator). It is
calculated as the ratio of share price to book value per share. The M/B ratio for
Tsingtao in 2000 is
Current share price HK$2.34 / share
M / B ratio Tsingtao = = = 0.9957 ≈ 1.
Book value per share HK$2.35 / share

According to this, Tsingtao is selling for the historical cost of the capital invested in
the business. Under most typical business conditions this is interpreted as a clear signal
that the company is probably undervalued and therefore a true investment opportunity.

Other Multiples. Two other comparison ratios or multiples may provide additional
insights into Tsingtao’s value. The 2001 forecast P/S ratio (price per share versus fore-
cast sales per share) for Tsingtao by Deutschebank Securities was 0.56 compared with
the Hong Kong H-share forecast of 0.85. This would imply an undervaluation of
Tsingtao, depending on the true comparability of the other firms in the comparison.
A similar type of ratio, the ratio of 2001 forecast enterprise value (market value of
debt and equity, EV) to basic business earnings (EBITDA) for Tsingtao was 7.5 com-
pared with the Hong Kong H-share forecast of 3.7 implied a different perspective—
overvaluation. The difficulty in interpreting these relative measures of value is in how
Tsingtao compares with the other firms traded as H-shares on the Hong Kong stock
exchange.

Summary of Valuation Measures

Exhibit W.6 summarizes the various measures of Tsingtao’s valuation discussed. As is
often the case in corporate valuations—domestic or cross-border—much of the infor-
mation is conflicting. What is Tsingtao worth? Value, like beauty, is in the eyes of the
beholder.
E X H I B I T W. 6
Summary of Valuation Method Share Price Observations
Valuation Current share price Rmb2.34 Baseline
Measures for
Tsingtao Brewing Discounted cash flow Mean = Rmb2.43 Implies Tsingtao undervalued
Company Ltd. (wide range)
(Rmb/share P/E ratio 34 to market’s 12 Tsingtao’s potential may already be
and HK$/share) included in the price
M/B ratio 0.9957 or 1 Tsingtao is undervalued
P/S ratio 0.56 to market’s 0.85 Tsingtao is undervalued
EV-to-EBITDA ratio 7.5 to market’s 3.7 Tsingtao is overvalued
 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation
MINI-CASE
Acquisition and Corporate Governance Failures: The Case of Telecom Italia
Some of the gaps and failures in corporate governance
are illustrated by the ownership changes of Telecom Italia
(Italy) between 1997 and 2001. When privatized in 1997,
Telecom Italia (TI) was the largest privatization in
Continental European history. By 1998 TI was the sixth
largest phone company in the world, employing more
than 80,000 workers. In addition to its traditional fixed
line telephony services, TI also held 60% ownership in
Telecom Italia Mobile (TIM). TIM held an 80% market
share of mobile telecommunications services in Europe at
that time. Telecom Italia’s performance had been deterio-
rating. Franco Bernabè, an experienced turnaround artist
at another Italian privatization, was convinced to take
over the challenge of revitalizing Telecom Italia in
November 1998.
Olivetti. On February 20, 1999, Olivetti (Italy) announced
a public tender offer for Telecom Italia of €10 per share. At
this time the single largest shareholder in TI was the Italian
government, whose remaining ownership in the company
totaled 3.4% of the outstanding shares. Olivetti, however,
was only a vehicle for the acquisition. A group of investors
from Brescia, Italy, who saw the highly fragmented owner-
ship structure of TI as an opportunity, sought out Roberto
Colannino. Colannino controlled a company called Hopa.
Hopa, in conjunction with the Brescia Group, formed Bell,
an Italian holding company, to gain control of Olivetti. As
illustrated in Exhibit 1, Bell gained control over Olivetti with
only a 23% ownership share.
Telecom Italia’s CEO, Franco Bernabè, who had been on
the job at TI for only three months, rejected the approach by
Olivetti and its CEO, Roberto Colannino. Bernabè publicly
fought the takeover attempt, exploring all the usual tactics
to defend TI against a hostile takeover. Colannino promised
shareholders an improvement in TI’s performance through
a series of cost-cutting measures, including a reduction in
employment that would dismiss 20,000 people. Bernabè
responded in kind, promising the same 20,000 head-count
reduction plus an additional 20,000 reduction through the
selective sale of various TI businesses.
In March 1999, Bernabè proposed to his stockholders
that TI buy all the remaining publicly held shares of
Telecom Italia Mobile, making the purchase price of TI
higher and the debt carried by TI higher. Both results
would make the hostile acquisition by Olivetti more diffi-
cult. An additional component of this defensive strategy
W-19
was that Bernabè believed if TI raised this much addi-
tional debt, it would be effectively using up much of the
available lending capacity in Italy for acquisitions at this
time, shutting Olivetti out of raising large sums of debt
capital to finance its own acquisition bid.
In late March TI’s stockholders accepted the tender
offer of Colannino and Olivetti. The offer price, now €11.50
per share, cost Olivetti $65 billion. Two additional issues
came to light after the shareholders’ acceptance of the
Olivetti bid. First, Olivetti had added a manipulative tactic
the day before the shareholder meeting: It had sold 24.4
million shares of TI in one day, sending TI’s price down
markedly. This acted to increase the attractiveness of the
tender price the following day. Second, and of more con-
sequence in the following years, Olivetti had acquired an
enormous amount of debt in order to finance the acqui-
sition, making this a true leveraged buyout (LBO). Olivetti
would be required to devote significant proportions of its
cash flows to debt service.
Over the following two years the new CEO Roberto
Colannino drained Telecom Italia of its earnings. Olivetti
instructed TI to distribute over 90% of earnings to the con-
trolling owner, Olivetti, to aid in its ability to service its
debt.The minority shareholders in Telecom Italia were furi-
ous and frustrated. TI’s earnings were being siphoned off
for Olivetti’s exclusive benefit, leaving TI’s capital expendi-
ture in investments significantly behind its competitors.
As illustrated in Exhibit 1, Olivetti had effected the
takeover of Telecom Italia with a series of interconnected
controlling interests. This structure, often referred to as
Chinese boxes or a corporate cascade, allowed Colannino
and the Brescia Group to gain control over an enormous
quantity of assets/businesses with little initial invest-
ment. In many countries this would be prohibited, but not
in Italy at this time.
Pirelli/Benetton. Telecom Italia’s share price, like that
of most telecom companies worldwide, languished
throughout 2000 and early 2001. In July 2001, the same
Brescia investors behind the previous hostile acquisition
now saw an opportunity to exit the business with a sig-
nificant profit. Marco Tronchetti Provera, the chairman
and CEO of Pirelli (Italy), in combination with Benetton
(Italy), formed a new holding company named GPI Newco,
which was owned 60% by Pirelli and 40% by Benetton.
They approached the Brescia Group, independently of
W-20 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation

EXHIBIT 1
Olivetti’s Takeover of Bell was in turn controlled by Roberto
Telecom Italia, 1999 Bell Colannino through another investment
(Italian Holding Company) company, Hopa. Hopa, in conjunction
with the Brescia Group, gained control
of Olivetti with just a 23% share.
23% share
ownership

Once in control of Olivetti, Colannino

led the hostile takeover (initially) of
Telecom Italia. This provided a highly
levered control of both Telecom Italia
and Telecom Italia Mobile with very
little capital invested.
55% share
ownership

Telecom Italia
60% share
(sixth largest telephone
company in the world) ownership

Roberto Colannino, and offered to purchase its holdings
in Bell at an 80% premium over what they had invested.
The Brescia Group was more than happy to accept.
Colannino, no longer in control of either Olivetti or
Telecom Italia, resigned. Because this controlling interest
in Bell, Olivetti, Telecom Italia, and Telecom Italia Mobile
was not through the public markets, none of the existing
shareholders—minority shareholders—reaped any bene-
fits from the change in control.
This move by Provera was not well received by his
shareholders. On the date of Pirelli’s announcement of its
acquisition of control in Olivetti and Telecom Italia, Pirelli’s
shares lost roughly one sixth of their value. The invest-
ment of €7 billion by Provera used the entire proceeds of
two optical units sold in late 2000 by Pirelli. Investors had
hoped for a better utilization of this capital than a lever-
aged entrance into the telecom industry. Once again,
minority shareholders, this time in Pirelli, reaped no
rewards, and many exited the investment as a result of
their unwillingness to hold shares in a firm that was now
in the telecom industry.
The corporate cascade of both listed and unlisted com-
panies participating in the control of Telecom Italia was
now larger than ever. As illustrated in Exhibit 2, a few
investors in a few companies now controlled a significant
share of Italian and Continental European business.

EXHIBIT 2
Pirelli’s Takeover of
Telecom Italia, 2001 Bell GPI/NewCo
(Italian Holding Company) (60% Pirelli, 40% Benetton)

23% share Pirelli gains control

ownership of Olivetti by buying Pirelli
Bell‘s 23% stake in Italian tire and cablemaker
Olivetti from the M. T. Provera, Chairman
Brescia Group.

Benetton

ownership

Telecom Italia
60% share
(sixth largest telephone
company in the world) ownership
 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation
SUMMARY OF LEARNING OBJECTIVES
Examine recent trends in cross-border mergers and
acquisitions
• The number and dollar value of cross-border mergers
and acquisitions has grown rapidly in recent years, but
the growth and magnitude of activity is taking place in
the developed countries, not the developing countries.
Evaluate the motivations for MNEs to pursue cross-
border acquisitions
• As opposed to the fighting and scraping for market
share and profits in traditional domestic markets, an
MNE can expect greater growth potential in the global
marketplace. There are a variety of paths by which the
MNE can enter foreign markets including greenfield
investment and acquisition.
Identify the driving forces behind the recent surge in cross-
border mergers and acquisitions
• The drivers of M&A activity are both macro in
scope—the global competitive environment—and
micro in scope—the variety of industry and firm-level
forces and actions driving individual firm value.
• The primary forces of change in the global competi-
tive environment—technological change, regulatory
change, and capital market change— create new busi-
ness opportunities for MNEs, which they pursue
aggressively.
Detail the stages in a cross-border acquisition and show
how finance and strategy are intertwined
• The process of acquiring an enterprise anywhere in
the world has three common elements: 1) identifica-
tion and valuation of the target; 2) completion of the
ownership change transaction (the tender); and 3) the
management of the postacquisition transition.
Examine the difficulties in actually settling a cross-border
acquisition
• The settlement stage of a cross-border merger or
acquisition requires gaining the approval and cooper-
ation of management, shareholders, and eventually
regulatory authorities.
Show how the complexities of postacquisition manage-
ment are related to the creation of value
• Cross-border mergers, acquisitions, and strategic
alliances, all face similar challenges: They must value
the target enterprise on the basis of its projected per-
W-21
formance in its market. This process of enterprise val-
uation combines elements of strategy, management,
and finance.
Identify the legal and institutional issues regarding corpo-
rate governance and shareholder rights as they apply to
cross-border acquisitions
• One of the most controversial issues in shareholder
rights is at what point in the accumulation of shares is
the bidder required to make all shareholders a tender
offer. For example, a bidder may slowly accumulate
shares of a target company by gradually buying shares
on the open market over time. Theoretically, this share
accumulation could continue until the bidder had 1)
the single largest block of shares among all individual
shareholders; 2) majority control; or 3) all the shares
outright.
• Every country possesses a different set of rules and
regulations for the transfer of control of publicly
traded corporations. This market, the market for cor-
porate control, has been the subject of enormous
debate in recent years.
Explain the alternative methods for valuing a potential
acquisition target
• There are a variety of valuation techniques widely used
in global business today, each with its relative merits. In
addition to the fundamental methodologies of dis-
counted cash flow (DCF) and multiples (earnings and
cash flows), there are also a variety of industry-specific
measures that focus on the most significant elements of
value in business lines.
• The DCF approach to valuation calculates the value
of the enterprise as the present value of all future free
cash flows less the cash flows due creditors and minor-
ity interest holders.
• The P/E ratio is an indication of what the market is
willing to pay for a currency unit of earnings. It is also
an indication of how secure the market’s perception is
about the future earnings of the firm and its riskiness.
• The market-to-book ratio (M/B) is a method of valu-
ing a firm on the basis of what the market believes the
firm is worth over and above its capital, its original
capital investment, and subsequent retained earnings.
W-22 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation
Questions
1. Shareholder Value. If most bidders pay the owners
of the target firm the “true value” of the firm, how
does a bidder create value for its own shareholders
through the acquisition?
2. Management and Shareholder Value. Why is it that
acquisitions provide management with a greater
potential for shareholder value creation than inter-
nal growth?
3. Cross-border Drivers. List and explain at least six
drivers for cross-border mergers and acquisitions.
4. Stages of Acquisition. The three stages of a cross-
border acquisition combine all elements of business
(finance, strategy, accounting, marketing, manage-
ment, organizational behavior, etc.), but many peo-
ple believe finance is relevant only in the first stage.
List specific arguments why finance is just as impor-
tant as any other business field in stages two and
three of a cross-border acquisition.
5. Shareholder Rights. Why do many national govern-
ments create specific laws and processes for one
company to acquire the control and ownership of
another company? Why not just let the market oper-
ate on its own?
6. Settlement. What factors are considered when decid-
ing how to settle an acquisition in cash or shares?
7. Corporate Cascades. Why do some countries object
to multiple levels of ownership control as seen in the
case of Telecom Italia? Do minority shareholders get
treated any differently in these cascades than in
other ownership structures?
8. Free Cash Flow versus Profit. Consider the following
statement: “Academia always focuses on the present
value of free cash flow as the definition of value, yet
companies seem to focus on ‘earnings’ or profits.”
a. Do you think this is true?
b. What is the basic distinction between cash flow
and profit?
c. How do we convert a measure of profit (say, net
income on a profit-and-loss statement) into a
measure of cash flow?
9. Discounted Cash Flow Valuation. Discounted cash
flow (DCF) valuation requires the analyst to esti-
mate and isolate the expected free cash flows a spe-
cific asset or investment will produce in the future.
The analyst then must discount these back to the
present.
a. Are the cash flows and discount rate before or after
tax? Do the rates need to be the same or should
one be before tax and the other after tax?
b. Where does the discount rate for the investment
come from? What assumptions should it make
about the way the investment will actually be
financed?
c. A very common criticism of DCF is that it “pun-
ishes future value and therefore is biased against
long-term investments.” Construct an argument
refuting this statement.
10. Comparables and Market Multiples. What valuation
insight or information is gained by looking at market
multiples like P/E ratios that is not captured in the
information gained through discounted cash flow
analysis?
11. Market-to-Book. What is the market-to-book ratio,
and why is it considered so useful in the valuation of
companies?
12. Tsingtao (A). Recommend which valuation mea-
sure, or combination of valuation methods, AB
should use.
13. Tsingtao (B). What share price should AB offer? Is
this an opening offer or best offer in negotiations?
14. Tsingtao (C). Identify the postacquisition (Phase
III) problems that AB is likely to face if it acquires a
larger minority ownership position in Tsingtao.
Problems
1. P/E Valuation of Global.com. A new worldwide cel-
lular phone company, Global.com (USA), is one of
the new high-flying telecommunication stocks which
are valued largely on the basis of price/earnings mul-
tiples. Other firms trading on U.S. exchanges in its
similar industry segment are currently valued at P/E
ratios of 35 to 40. Given the following earnings esti-
mates, what would you estimate the value of
Global.com to be?
Last Year’s This Year’s Next Year’s
EPS EPS EPS
$(1.20) $0.75 $1.85
 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation W-23

2. Bidding on São Paulo Cellular Rights. A consortium ex post basis (expected values after capital and manage-
of global telecommunication firms is about to submit ment expertise injections).
a bid to purchase the rights to provide cellular tele- The second major set of “ifs” associated with acquir-
phone services to central São Paulo. The bid must be ing Guga is what it could sell for in three years. The Soto
submitted, and payment made if awarded the bid, in Group has an unbending internal rule that every firm
U.S. dollars, not in Brazilian real (R$). The consor- acquired must be restructured, revitalized, and ready for
tium has finalized the following forecasts of cash public sale in three years from deal consummation, or
flows, exchange rates, and potential discount rates. less. Given market multiples on the Buenos Aires Bolsa
at this time, a value of 18 to 20 times current free cash
Year 0 Year 1 Year 2 Year 3 flow (year 3) would be considered aggressive. The a pri-
Estimated CF ori analysis, acquired from Guga Avionics and adjusted
(millions of R$) by Soto’s own valuation and market experts, appears in
Best case (1,350) 550 2,000 3,800 Exhibit W.7.
Moderate case (1,350) 550 1,600 3,200
E X H I B I T W.7
Worst case (1,350) 550 1,000 1,500
Expected Exchange A priori Financial Forecast
Rate (R$/$) Guga Avionics, Buenos Aires, Argentina (millions of
Argentine pesos)
Best case 1.70 1.70 1.70 1.70
Year 0 Year 1 Year 2 Year 3
Moderate case 1.70 1.80 1.90 2.00
Gross revenues 210 235 270 325
Worst case 1.70 2.00 2.20 2.50
Less direct costs (132) (144) (162) (190)
Discount rate
Gross profit 78 91 108 135
(R$ terms) 32.0%
Gross margin 37% 39% 40% 41%
Discount rate
(US$ terms) 18.0% Less G&A (16) (17) (18) (19)
Less depreciation (24) (24) (24) (24)
Perform a DCF analysis on the potential investment and EBIT 38 50 66 92
propose a final bid for submission. Less interest (28) (30) (30) (28)
EBT 10 20 36 64
Private Equity in Latin America—The Soto Group. Less taxes @ 30% (3) (6) (11) (19)
(Use the following private equity problem to answer
Net profit 7 14 26 45
Questions 3 through 5) Private equity focuses on pur-
chasing small privately-held firms, restructuring them Return on sales 3% 6% 9% 14%
with infusions of capital and professional management,
and reselling them several years later (either to another
The Soto Group believes that it can reduce financing
private buyer or through a public offering). This means
expenses by 25% in years 1 and 2, and 35% in year 3. It
that their value to the private equity investors is in their
also believes that by using its own operational experi-
terminal value—their value when taken public several
ence, it can reduce direct costs by 15%, 20%, and 25% in
years from now.
years 1, 2, and 3, respectively. The big question is revenue
The Soto Group is a private equity fund based in
enhancement. Guga has done a solid job of promoting
Mexico City. The Group is evaluating the prospects for
and expanding service revenues in the past several years.
purchasing Guga Avionics (Buenos Aires), an aviation
At most, the Soto Group believes it may be able to
operating and management firm with current business
expand gross revenues by 5% per annum over current
operations throughout Argentina and southern Brazil. The
forecasts.
Soto Group has, through their due diligence process,
acquired the needed financial statements, inventory of 3. Guga Avionics Valuation (A). Using this data, as the
assets, and assessment of operations. Soto’s valuation staff lead member of the Soto Group’s valuation staff,
typically values the potential target on both an a priori what is the difference between a priori and ex post
basis (current structure and management strategy) and an earnings and cash flows?
W-24 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation

4. Guga Avionics Valuation (B). What is the difference b. Assuming a terminal value growth rate of 0%,
between a priori and ex post sale value at the end of what is the DCF equity value per share? What
year 3? percentage of the total DCF value is the terminal
value?
5. Soto Group and Guga Avionics. What would you
recommend—in addition to the current Soto plan— 9. Tsingtao Brewery Company (D). One of AB’s ana-
to enhance the profit and cash flow outlook for lysts is quite pessimistic on the outlook for Tsingtao.
Guga if acquired? Although the company did indeed make major
strides in reducing NWC needs in recent years, much
Tsingtao Brewery Company. Use the spreadsheet analy- of that was accomplished before really tackling the
sis of Tsingtao Brewery Company (spreadsheet on Web complexity of absorbing many of these new acquisi-
site) that appears in the chapter to answer Questions 6 tions. The analyst argues that, at best, sales growth
through 10. will average 12% for the coming five-year period
6. Tsingtao Brewery Company (A). As described in the and that NWC will most likely rise to 3% of sales
chapter, Anheuser Busch (AB) is interested in fur- (baseline assumption was 1%). What does this do to
ther analysis of the potential value represented by the equity valuation of Tsingtao?
the new-found strategic and operational direction of
10. Tsingtao Brewery Company (E). Finally, the valua-
Tsingtao. The baseline analysis assumed some rather
tion staff wants to address a full scenario of what
aggressive growth rates in sales. AB wishes to find
they consider best-case and worst-case analysis,
out what the implications are of slower sales growth,
assuming the baseline analysis is somewhere in
say 15% per annum throughout the 2001 to 2005
between (moderate).
period, on the discounted cash flow equity value of
the company. And, assuming sales growth is indeed Best Case Baseline Worst Case
slower, AB wishes to determine the compounded
Sales growth 20% Variable 10%
impact of a declining NOPAT margin, say 3.6% of
sales, rather than the baseline assumption of 4.2% of NOPAT of sales 4.4% 4.2% 3.6%
sales, on equity value. Perform the analysis. Depreciation 8.5% 7.5% 6.5%
NWC of sales 0.8% 1.0% 3.0%
7. Tsingtao Brewery Company (B). Returning to the
Capex of sales 1.5% 2.5% 3.5%
original set of assumptions, AB is now focusing on the
capital expenditure and depreciation components of Terminal value growth 2.0% 1.0% 0.0%
the valuation.Tsingtao has invested heavily in brewery
upgrades and distribution equipment in recent years, Evaluate the best-case and worst-case scenarios for
and hopes that its capital expenditures are largely Tsingtao.
done. However, if a number of the recent acquisitions
require higher capex levels,AB wants to run a scenario
to focus on that possibility. What is the impact on Internet Exercises
Tsingtao’s discounted cash flow value if capex expen-
ditures were assumed to be 3.5% of sales rather than 1. Intellectual Property and Valuation. The late 1990s
the baseline assumption of 2.5%? What is the result of saw the rise of corporate valuations arising from
combining that with an assumed depreciation level of ownership of various forms of intellectual property,
8.5% as opposed to 7.5% (baseline) for the time rather than the traditional value arising from goods
period of the analysis? or services production and sale. Use the following
8. Tsingtao Brewery Company (C). Returning to the Web site as a starting place and prepare a manage-
original set of assumptions, one of the truly contro- ment brief on the current state of valuing intellectual
versial components of all discounted cash flow property.
analysis is the impact terminal value calculations Intellectual Property Valuation
have on equity value. AB wishes to explore the fol- http://valuationcorp.com/
lowing sensitivities to the DCF valuation: 2. Market Capitalization of Brahma of Brazil. Brahma
a. Assuming no terminal value, what is the DCF is one of the largest publicly-traded firms in Brazil. It
equity value per share? is listed on both the Bovespa and the New York
 WEB CHAPTER | Cross-Border Mergers, Acquisitions, and Valuation W-25

Stock Exchange (ADRs). Using historical data that a. How did Brahma’s share price—in both real
can be found on one of the sources below, answer the and U.S. dollar terms—react to the January
following questions. 1999 Brazilian real devaluation?
Hoovers http://www.hoovers.com b. Would a firm like Brahma be a more or less
Yahoo http://www.yahoo.com attractive target of foreign investors after the
real’s devaluation?